Fevertree Drinks isn’t the only high-flying stock I’d sell today

Deciding when to sell a stock is never easy at the best of times. It’s particularly difficult if you believe the company in question has a strong business and management, a robust balance sheet and so on.

Yet no matter how good a company is, its shares can reach a level where the valuation is so rich that it makes sense to sell the stock and look for better value elsewhere. I believe this is the case with two high-flying stocks in the top echelon of the FTSE AIM index, namely Polar Capital Holdings(LSE: POLR), which released its annual results today, and Fevertree Drinks (LSE: FEVR), the second-largest company in the index behind online fashion giant Asos.

268% gain since IPO

Polar Capital Holdings is a specialist active investment management company aimed at professional and institutional investors. Small private investors may not have heard of its funds (they include Automation & Artificial Intelligence, Global Convertible and European Forager hedge fund), although its three investment trusts, by far the largest of which is Polar Capital Technology Trust, may be familiar to some.

The company was founded in 2001 and joined AIM in February 2007, with a 190p-a-share placing giving it a market-cap of £120.5m. The shares closed last week at a new all-time high of 692p and topped 700p after this morning’s results.

Strong results

The company reported an 85% increase in total net revenue to £125.9m for its financial year ended 31 March, with net management fees up 33% to £90.3m and performance fees rocketing by over 1,200% to £35.6m from £2.7m. However, costs also increased significantly. Total operating costs rose 78% to £87.9m, including increases in staff numbers, discretionary bonuses and, most notably, performance fee interests, up to £20.3m from £1.5m.

Nevertheless, the company delivered strong bottom-line growth, with adjusted basic earnings per share (EPS) and adjusted diluted EPS (which takes account of the significant share options held by directors and staff) both up 79% to 38.4p and 36.6p, respectively. This compares with analyst expectations of 35.6p when my Foolish colleague Edward Sheldon looked at the company in March. Edward was particularly interested in the dividend, which was forecast to rise to 26.4p from 25p. So he will be pleased with the payout of 28p announced by the board today.

Valuation

At a share price of 700p, Polar’s price-to-earnings (P/E) ratio is just over 19 on a diluted EPS basis and the dividend yield is bang on 4%. The earnings multiple isn’t outrageous, particularly as the company reported net cash of £87.9m on its balance sheet at the year end. Similarly, while there are higher yields available from blue-chip fund managers — Schroders (non-voting shares) at 4.5% and Standard Life Aberdeen at a whopping 6.2% — Polar’s 4% is pretty decent. Certainly, neither the P/E nor the dividend yield are at levels that might suggest the stock is an obvious ‘sell’.

However, my favoured valuation metric for fund managers is based on assets under management (AUM). My rule of thumb is that a company valued at up to 3% of AUM is generally good value. I might continue to hold the stock if the valuation rises to 4%, but once it gets above that, it moves into ‘sell’ territory, in my book.

Polar today reported AUM of £13.4bn as of 31 May. At a share price of 700p, the company’s market cap is £655m, which represents 4.9% of AUM. I see this as a late-stage bull market valuation, which offers investors little margin of safety. And I believe now could be an opportune time to sell the stock.

Early mover

Polar has delivered an excellent return for investors since its IPO, but the return has been spectacularly eclipsed by that of Fevertree Drinks, which was founded in 2004 and listed on AIM in November 2014. At the IPO price of 134p, Fevertree’s market cap was £154.4m. Today, the shares are trading at over 3,400p and the market cap is not far short of £4bn.

Fevertree’s founders were quick to spot the opportunity from growth in consumer demand for artisan gins. Disgusted by the “artificial, saccharine-packed tonics” that dominated the market, they set out to make a premium Indian Tonic Water from fresh, natural ingredients. The business took off and the company has since rapidly expanded, internationally and into other mixers.

Competitors slow to respond

Growth has been phenomenal, exceeding the expectations of City analysts and the founding directors from the outset. The pricing of the IPO soon looked to be a huge bargain, representing a P/E of just 11.7, based on diluted EPS of 11.48p posted in its first full financial year after listing. The next year saw a 106% increase to 23.7p, followed by a 65% rise to 39.15p last year. At the current share price, the P/E is an eye-watering 87.

I think part of the reason why Fevertree has been so successful is because competitors were so slow to respond. The company made a telling comment in its AIM admission document: “The biggest single brand of tonic water worldwide is Schweppes. However, since the break-up of Cadbury Schweppes in 2008, the Schweppes brand has a highly fragmented ownership (over 10 companies), especially in Europe, with no central brand stewardship, strategy or marketing.”

This played into Fevertree’s hands. When Schweppes did get round to responding with its premium Schweppes 1783 mixers and a multi-million-pound campaign in the UK, Fevertree was already become the best selling mixer brand in Britain’s shops.

Tougher going forward

Much as I admire Fevertree, I rate the stock a ‘sell’ today, due to that eye-watering P/E of 87. Rising competition not only from Schweppes, but also others, including new entrants, represents a tougher environment for Fevertree going forward. And while the company certainly has good international expansion opportunities, this also comes with execution risk. Given that risk and with City forecasts of annual EPS growth moderating to a percentage in the teens, a P/E of 87 simply looks far too fizzy to me.